Pay Compression: 3 warning signs and 5 correction strategies

One of the most serious business impacts of wage inflation is pay compression. Pay compression is an imbalance in job pricing that can create tension inside an organization and threaten its ability to be competitive in a tight labor market. It’s one of the many challenges Lou Lazo, Employers Council Consultant, works through with member organizations. Lou has spent almost 40 years in human resources and specializes in compensation and market pricing. 

“Pay compression takes a number of different forms, but the one that is most important right now is where candidates coming from outside an organization are demanding or commanding prices that are higher than what is being paid inside the organization,” said Lou. 

Organizations who don’t have a strategy to correct that kind of pay compression can face unexpected financial burdens, not to mention legally risky overlaps with pay equity concerns. “If you don’t fix pay compression, you’ll either lose people and still have to spend the higher going market rate to replace them, or you’ll lose productivity by hiring lower quality people,” explained Lou. 

Another common form of perceived compression is where a subordinate makes close to or more than their manager. 

“I don’t lose any sleep over that,” said Lou. “If the manager job is appropriately priced, and the subordinate job is appropriately priced, and the incumbents are each paid based on what they are bringing to the party, it’s entirely possible that a highly experienced subordinate is going to make more than a less experienced manager.”

“But when pay compression is coming from the outside, it means you have had a failure of internal systems,” said Lou. 

Pay compression warning signs

How can your organization know when pay compression needs to be addressed? There are three main red flags that can alert HR departments that they might need to do some compression correction: 

Sign #1: Recruiting conversations

“Recruiting is the canary in the coal mine for compensation,” said Lou. “If you’re talking to people who are similarly situated to your employees, and they are asking for bigger numbers than what you’re currently paying, that’s your first warning sign.” 

Sign #2: Employment Cost Index (ECI) 

The Bureau of Labor Statistics issues the Employment Cost Index quarterly. It tracks changes quarter-to-quarter and year-over-year. “If those numbers look bigger than your normal merit budgets or your normal change of pay, that’s another early warning sign that you’ve got compression coming your way,” said Lou.  

Sign #3: Inflation rate 

“Labor inflation is a lagging result,” said Lou. “Whenever we see consumer price inflation numbers go up, that’s another early warning sign that at some point down the road,  maybe in another year, we will see wages responding to that.” 

Lou cautioned organizations to also watch for particular job or job segments with rising demand. A shortage in needed roles can create isolated pay compression spikes. (Think about how nursing pay skyrocketed during the height of the pandemic, for example.) Right now, entry level jobs are seeing the biggest movement in salaries, which is causing pay compression on the lower end of the employment spectrum. 

How to correct pay compression

“Organizations are asking what can I do tactically and what can I do strategically…,” said Lou. “The strategic solution is to push reset and get everybody right.” 

Here the steps organizations can take to correct pay compression:    

1. Determine what you can afford. 

What is your budget for correcting pay compression? Keep in mind that pay compression will cost you, whether in internal pay increases, higher pay for new employees, or lost productivity. One way to find more money for correcting pay compression is to apply productivity gains to the payroll budget. Are there any positions that don’t need to be filled because your current team is excelling? Instead of hiring, use the budget from those salaries to bring your top performers up to competitive rates. 

2. Compile your performance and experience data. 

“Organizations have to be smart and analytical about it,” said Lou. “Look at some combination of time in job and performance and then make a decision about where in the pay range a person with that combination of skill and experience should fall.” HR departments can use that model to both fix pay for incumbent employees whose compensation is lower than it should be and make pay decisions when bringing on new hires. 

3. Prioritize pay compression corrections. 

If you don’t have the budget to bring all employees’ pay into alignment with current market conditions, then you’ll need to make some hard decisions. Which high performers or key positions do you need to make sure you stay competitive? Are there positions that you could afford to lose and/or replace with less experienced workers? 

4. Hedge your bets with new employees. 

Lou said that many organizations don’t feel comfortable paying a new employee the same as a proven employee. Companies can remain competitive when hiring by offering a starting salary with a built-in review and raise within a certain amount of time. “Pay almost what you think they are worth and then confirm it,” suggested Lou.  

5. Make sure your annual increased pay budget reflects what is happening in the market. 

To avoid future pay compression problems, make sure you are using real-world numbers to determine yearly merit and cost-of-living raises. 

Ready to learn more about wage inflation — and smart ways to counter its effects? Register for “Strategies for Managing the Business Impacts of Wage Inflation,” our first Exceptional Workplace Series session of 2023. This 30-minute, on-demand video will be released on February 27. Access is free for members and $40 for non-members.

REGISTER NOW

Need help crafting a pay compression correction strategy for your organization? Employers Council can help in several ways: 

• Our Compensation Planning Services team can help you determine the fair market value of different positions. 
• Our Outsourced HR Support Services team can help you craft performance management systems necessary to build accurate pay compression models. (Which our consultants can also help you create!)
• Pay compression conversations sometimes overlap with pay equity questions. Our Legal Services team can help you stay in compliance with pay equity laws. 

Contact us to discuss how we can best help you correct pay compression.